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Whenever people talk about bonds, they tend to refer to them as a secure way to earn regular income. Bonds are much more secure than many other instruments, but there is one thing investors should consider: bond yields.
Bond yield is the rate at which the income from a bond can be expected based on the price of the bond.
This article will explain bond yields, how they are calculated, the various types of bond yields, and more.
Key Takeaways
- Bond yield shows the return an investor can earn from a bond.
- Bond prices and yields generally move in opposite directions.
- Higher yields can mean higher risk, so investors should not choose bonds based on yield alone.
- Interest rates, inflation, credit risk, and maturity are important factors that influence bond yields.
- Coupon rates and bond yield are different. The coupon is usually fixed, while yield changes with the bond's market price.
What is a Bond Yield?
The bond yield refers to the return from the investment in a bond.
If you purchase a bond, you basically lend your money to the government, a firm, or any other entity. The borrower typically makes a promise to pay you interest periodically and gives you back the principal amount at maturity.
For example, if you purchase a bond of ₹1,000, which pays ₹80 as interest every year, then you earn ₹80 per year from the bond.
In its basic formula, the current yield would be:
Current Yield = Annual Interest Payment ÷ Current Bond Price × 100
If the bond is priced at ₹1,000:
₹80 ÷ ₹1,000 × 100 = 8%
So, the current yield of the bond will be 8%. Calculating the bond yield can get complex due to changes in the bond price.
Importance of Bond Yields
Bond yield is significant since it enables the investor to compare various fixed income securities.
Let us consider two bonds:
- Bond A pays a 6% yield.
- Bond B pays a 9% yield.
The first impression will be that Bond B is a better investment than Bond A. The high yield could be due to high risk, longer maturity, or any other drawback. Considering yield with the factors of risk, maturity, creditworthiness, inflation, and interest rates provides a clearer picture.
Bond yields are significant not only from an investment perspective but also for a country’s economy. They have the potential to impact the cost of borrowing for various economic activities. That is why the financial market monitors various government bond yields.
Relationship Between Bond Prices and Yields
There is a simple rule of thumb in the bond market. When bond prices rise, yields fall. When bond prices fall, yields rise. Let us understand this through a simple illustration.
Suppose a bond gives you ₹100 per annum. If you buy this at a price of ₹1,000, then your current yield is 10%.
Suppose due to high demand, the price rises to ₹1,250. However, you will continue to receive ₹100 as an annual interest.
Then your yield becomes:
₹100 ÷ ₹1,250 × 100 = 8%
In this case, although the price has gone up, the yield from the interest received has fallen.
On the other hand, suppose the price falls to ₹800. However, you still receive ₹100 per annum.
Then your yield becomes:
₹100 ÷ ₹800 × 100 = 12.5%
The inverse relationship between bond prices and yields is one of the most important aspects of bonds.
How is Bond Yield Calculated?
There are various ways to calculate bond yields. It depends on what you need to know about bond investment.
Current Yield
The current yield is one of the most straightforward measurements.
Current Yield = (Annual Coupon Payment / Current Market Price) × 100
For instance, the annual coupon payment of a bond is ₹60, and the market price of the bond is ₹900.
Current yield:
₹60 / ₹900 × 100 = 6.67%
The current yield gives an idea about how much income is being generated from the bond's market price. But there are some other factors which are not considered by the current yield.
Yield to Maturity
The yield to maturity (YTM) is a more comprehensive indicator of the annual yield from a bond if it is purchased at the current price and held till maturity, with the assumption that the issuer will make all the payments.
The YTM takes into account the following factors:
- Current price of the bond
- Coupon payments
- Face value of the bond
- Time left to maturity
- Difference between the price paid and face value
For instance, consider a bond with a face value of ₹1,000 being sold at ₹950. When the bond matures, you can get ₹1,000 plus the interest payments you will receive in between. This ₹50 difference is part of your yield, and hence YTM is a better indicator than the coupon rate.
Yield to Call
Certain bonds are callable, which means that the issuer can repay the bond before its maturity date. In the case of callable bonds, another measure that is considered by investors is Yield to Call (YTC).
The YTC measures the return that an investor will get if the bond is called on the earliest call date. It is important because although the bond might have a good maturity yield, its return can be different when the bond is repaid early.
Also Read About: What is Nominal Yield?
Why Does Bond Yield Change?
There are various reasons why bond yields change. The most important reason is the interest rate.
An increase in the interest rate by the central bank means that new bonds will have higher returns. Bonds with lower coupon payments will become less attractive.
So, there will be sales of these bonds, causing their prices to fall while yields rise.
If the interest rate goes down, bonds having higher coupon payments will become more attractive, and their prices will rise. This means yields will go down.
Another major factor is the inflation rate. If the inflation rate increases, then investors will expect higher yields since they require compensation for losing purchasing power due to the high inflation rate.
The financial strength of the bond issuer is another factor. A government or firm considered safer to pay back the debts can offer lower bond yields compared to a riskier issuer, which needs to pay higher bond yields.
Difference Between Bond Coupon and Bond Yield
|
Bond Coupon |
Bond Yield |
|
Fixed interest rate promised by the bond issuer. |
Actual return an investor earns based on the bond's current price. |
|
Usually expressed as a percentage of the bond's face value. |
Changes as the market price of the bond changes. |
|
Generally, remains fixed throughout the bond's life. |
Can rise or fall over time. |
|
Example: ₹80 annual interest on a ₹1,000 bond = 8% coupon. |
If the same bond costs ₹800, its current yield is 10%. |
Conclusion
Bond yield is simply a way of understanding the return you can earn from a bond. Although the concept may seem difficult at first, the basic idea is straightforward. The most important points to remember are that bond prices and yields generally move in opposite directions; coupon rate and yield are not the same thing, and a higher yield often comes with higher risk. For beginners, current yield is easy to understand, while yield to maturity provides a more complete picture of a bond's potential return when held until maturity.
Also Read About: Bonds Vs Stocks
